To cook up growth in EU, mix macro policy with micro changes

The debate between austerity and expansionary policy obscures a crucial ingredient for successful economic growth: a fertile environment conducive to business

By Mark Roe

Is austerity dead? At last month’s G8 meeting at Camp David, the German-led austerity program for the eurozone’s troubled southern members ran up against substantial resistance. Likewise, France’s recent presidential election bolstered those who argue that Europe must grow its way out of its debt-heavy public sector, rather than aim for immediate fiscal orthodoxy. There is no guarantee that Greece’s newly elected center-right New Democracy party, which favors honoring the country’s bailout terms, will be able to form a majority government.

The US, by contrast, has pursued expansionary and growth-oriented macroeconomic policies since the 2007-2009 financial crisis, despite massive budget deficits. Thus far, judging from the modest recovery in the US versus non-recovery in Europe, US policy accommodation is performing better than European austerity.

However, simply choosing between expansion and austerity is not the whole story. Macroeconomic policies interact with on-the-ground microeconomic realities in subtle, but powerful, rarely remarked-upon ways. Simply put, Europe’s microeconomic structure makes the same growth-based macroeconomic policies less effective in the EU than in the US.

Here’s why: Macroeconomic easing, by lowering interest rates or otherwise pumping money into the economy, aims to increase economic activity. With more money moving around, businesses rehire employees and ask existing employees to work more hours. Entrepreneurs considering whether to start a business decide to proceed, and their bank lends them money to make the start-up viable.

The newly hired workers and newly formed businesses spend money, which induces more hiring, more start-ups and yet more spending. The economy grows, yielding higher tax revenues, thereby helping governments to put their fiscal house in order. The country grows its way out of its economic problems.

However, the EU cannot realize this scenario as easily as the US can, because micro-level rules in the EU generate friction that slows that kind of an expansion.

The EU’s stricter labor rules are a well-known and often-cited example. European labor-market rigidities mean that it is difficult in many EU countries to downsize a company. Anticipating that difficulty, companies are less willing to hire in the first place, until they are sure that long-term demand for their products is sufficient to justify long-term hires. Hence, even if businesses get easier access to money and loans, many firms will still decline to hire on a large scale, fearing that they would be saddled with a large payroll in a future downturn.

For example, The Economist’s recent portrait of Italian Prime Minister Mario Monti shows that Italy continues to be stymied by labor rules that make businesses reluctant to expand beyond 15 employees (after which it becomes hard for a firm to downsize). To work smoothly, expansive macroeconomic policies require compatible microeconomic rules.

There is some irony in the fact that the strongest proponent of austerity has been German Chancellor Angela Merkel’s government, because Germany, particularly under her predecessor Gerhard Schroeder’s Social Democrat-led government, did much more to liberalize its rules for labor and business than other EU governments. Expansive, growth-based policy could work better in Germany than in many eurozone countries for which it is being prescribed.